“Things that can’t go on forever, don’t.” If those famous words of the otherwise obscure Nixon-era economic advisor Herbert Stein apply to anything, it is health care spending. Most of us recognize that health care is expensive, breaking the budgets of many households, pressuring businesses and even challenging the spending capacity of giant Federal programs like Medicare and Medicaid. What is less clear is why this is so, and what can, or should, be done about it.

We spent more than $33 billion on health care in Indiana in 2004, the most recent year for which data are available. For the past four years spending on health care statewide has grown at an annual rate of 8.2 percent, nearly twice as fast as the 4.2 percent average growth in the entire state economy.

It’s not all bad news – we are getting something for all that money, after all. Roughly half of the increase in costs is due to increased utilization of health care goods and services. In fact, with our older, more affluent population, it would be a shock if we didn’t spend a bigger portion of our budgets – individually and collectively – taking care of ourselves.

But half of the higher spending tab is due to higher prices – for everything from drugs to hospital care. In an otherwise tame inflation environment, health care prices stand out as an area of the economy where sticker shock still prevails.

This is distressing, but to economists, at least, it is unsurprising. There are a number of aspects of health care policy in this country that feed the fires of health care spending growth, and indirectly support the ability of health care providers to push through high price hikes, beyond what might be possible in the rest of the economy. Some of these might surprise you.

The tax system might seem like a strange place to start when analyzing health care spending growth. But taxes do more than simply present us with bills to pay. They also can change our behavior. And in the case of health care spending, they encourage us to spend more on health care goods and services, even in the face of higher prices. Here is how it works.

When we buy food, purchase a car, or go to the movies, we pay for those things with what economists call after-tax dollars. Depending on exactly what income tax bracket you are in, you may need to earn as much as $1.30 or more to have a dollar available for spending after paying Uncle Sam. And that includes most of your out-of-pocket spending on medical care – for over the counter drugs, co-pays, and deductibles for private insurance -- as well.

But that’s not the case for health care spending that is covered by an employer-provided health care plan. The premiums that are paid by employers on our behalf are not treated as taxable income, unlike the wage money that your employer pays you in cash. That makes health care premiums cheaper than ordinary goods and services, since we only need $1 of income to pay for a dollars worth of health insurance coverage, but we need more than that to pay for a buck’s worth of most other things.

That sleight of hand in the tax code has had enormous implications. First off, we tend to buy more of things that are cheaper. So we buy more health insurance coverage. That’s why health insurance plans long ago pushed into things no ordinary insurance plan elsewhere would pay for, such as routine doctor visits. It’s cheaper, on an after-tax basis, to have the plan pay for such things than paying for them ourselves.

But doing so has blurred the connection between price and product. With a third-party insurance provider paying the bill, we may not even know the price of what we’re using. And our rising premiums reflect the costs of what all us consume, instead of the consumption choices we make individually.

Patrick Barkey is director of the University of Montana Bureau of Business and Economic Research. He has been involved with economic forecasting and health care policy research for over twenty-four years, both in the private and public sector. He served previously as Director of the Bureau of Business Research (now the Center for Business and Economic Research) at Ball State University, overseeing and participating in a wide variety of projects in labor market research and state and regional economic policy issues. He attended the University of Michigan, receiving a B.A. ('79) and Ph.D. ('86) in economics.

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